Market volatility has been near historic lows for the past two years, but now it’s back. Here’s why.

For the past two years, market volatility has been unusually low. One measure of stock market volatility has been running at nearly half its normal level. But this year, that’s changing.

Stocks soared the first few weeks of the year, only to fall recently. Currency and bond markets have been much more volatile as well. An index of Treasury market volatility has jumped 26% in the past three weeks. The benchmark 10-year Treasury yield reached 2.84% on Friday, the highest level in four years.

While I remain bullish, I am unconvinced that the recent pause in the stock market rally is complete. I think the odds of a garden variety correction—a drop of about 10%—are rising.

Why now, when the economy is so strong and earnings are mostly very positive? There are three main factors I believe have caused the shift:

Interest rates are higher and likely to keep rising. Bond yields are responding to higher inflation risks (and bond prices move inversely to yields). A jump in yields could be negative for stocks, which are valued in part based on their growth prospects compared to a risk-free Treasury rate. The weaker U.S. dollar is part of this story (See my post from last week, “Worrying About a Weaker Dollar”).

Economic strength, which ultimately translates to earnings growth, may have reached peak levels. Already some recent regional economic reports and manufacturing surveys have been a bit more mixed. Tax reform effects, a positive for earnings and economic momentum, are likely to fade.

Stress from Washington, which investors have mostly been ignoring, could be a source of volatility. Congress still needs to finalize the budget and raise the debt ceiling. Meantime, higher Treasury yields are driving up the cost of financing government debt. The fact that the nation’s $20 trillion in debt is now 100% of GDP is unlikely to go unnoticed by investors.

Bottom line: I don’t think the bull market has ended, but the odds of a correction are rising. I think the S&P 500 could end the year at 2750 – near where it is now, but I expect that there will be some ups and downs between then.

To manage rising volatility, I have been recommending investors diversify their holdings across sectors, asset classes and regions and also turn to actively managed portfolios, as opposed to index funds. Investors who want to minimize the impact of market volatility on their overall portfolio may want to add a fund that can take both long and short positions, potentially benefiting whether the broader market rises or falls.

Risk Considerations

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

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